Neoclassical Business Cycles

Aggregate data do not lend support to neoclassical business cycle models. Discuss this statement paying particular attention to inter-temporal decisions about consumption, labour/leisure and investment.

According to Prescott the reason for business cycles is due to technology shocks which manifest itself as changes in the TFP productivity term (or Solow residual) A. Summers criticises this explanation believing that Prescott doesn’t provide evidence for where these technology shocks come to. Furthermore he cites Berndt who shows that the oil shock crisis – recessionary periods in the 1970s for both the US and the UK – had little effect on labour productivity which would cast doubt on Prescott’s story. Summers also points out that US GNP declined by 50% between 1929 and 1933, and questions whether it is really plausible that such an output shock could be caused by a productivity shock which lead to inter-temporal substitution on such a scale, as Prescott’s model would predict.

Our neoclassical model would say that if there was a positive permanent productivity shock then the aggregate supply curve would shift rightwards as a result of the increased productivity of firms (capital) and labour. This higher income would cause consumption – which is a function of present value income – demand to shift rightwards, 1:1 with income, along with investment demand – which is a function of period 2’s productivity – which would shift by a large margin due to the high elasticity of investment to productivity. So in aggregate we would expect a large positive shift of the aggregate demand curve, which would exceed the shift in aggregate supply leading to higher output but also higher interest rates. In short, a positive productivity shock causes higher output, no change in labour supply, higher consumption and investment and a higher real interest rate.

If we examine a temporary productivity shock (A1 rises) then aggregate supply would shift rightwards due to the increased productivity of firms and labour. The higher income would again cause higher consumption, but the marginal propensity to consume would be low, so the shift of C would be small. Investment would not shift as this is a function of period 2 productivity, which hasn’t changed. In aggregate we would have a shift of the supply curve right, with a smaller shift in the demand curve. Hence real interest rates would fall and output would rise. Because labour productivity in period 1 increases – but not in period 2 – then period 1 wages will rise, whilst period 2 wages remain constant. Thus we expect inter-temporal substitution so that workers work more in period 1 when wages are higher.

Looking at the evidence we find that data shows r is weakly pro-cyclical, which would cast doubt on the temporary productivity shock story, which predicts countercyclical interest rates. This can be reconciled by incorporating the permanent productivity shock story, which does indeed predict pro-cyclical interest rates. The data also suggests that real wages are pro-cyclical, from our temporary productivity explanation we can see that this is indeed the case with inter-temporal substitution occurring so that workers work more in period 1 when wages are higher as a result of higher productivity. This isn’t the case in the permanent story, where wages in all periods rise such that there isn’t inter-temporal substitution in terms of labour supply.

So far it would seem that our model doesn’t do a bad job, as measured by its success with data. Yet Summers points out that just because a model correctly measures the observed data, doesn’t make it a good, or correct theory. We still have no explanation for where these productivity shocks come from, and why there are so frequent. According to Fay and Medoff changes in productivity over the business cycle is in fact due to firms hoarding labour during periods of output downturns, meaning that productivity is in fact endogenous to the system which could cause problems with our model. They show that the typical US manufacturing plant in the 1980s paid for 8% more worker-hour time than necessary for regular production. Moreover, Prescott himself points out that large fluctuations in output occur over short periods of time, with 10% fluctuations not being uncommon in a couple of years. He also points out that investment is 6 times as volatile in consumption. It is difficult to suggest that our model can predict such high volatility, even if it can explain general cyclical trends.